One of the major financial derivatives that find its way into the crypto-currency market is future contracts. Future contracts which is also one of the major financial derivatives is a major tool of risk management as well as speculations by traders of a particular commodity of value. In other words, it is a great way to transfer risk or even take on risk. The idea of Future Contracts has been existing for a very long time and they will continue to exist Therefore futures are a valuable addition to the Bitcoin Ecosystem.
First of All – So What are Future Contracts?
Future Contracts or Futures is simply nothing more than an agreement between two participants to buy or sell a certain commodity (financial instrument in this context) at a pre-determined price in the future and effectively locking a future price by so doing. Bitcoin Future Contracts revolves around users agreeing to buy or sell a specific amount of cryptocurrency once it reaches a predetermined price on a future date. A very good explanation is this – A buyer of a future contracts buys the right to sell Bitcoins at a specific price. The seller agrees to accept the Bitcoins at a specific future date for that particular price.
Brief History of Future Contracts?
Future Contracts have been used as a business tool of risk management for centuries while modern futures trading began to evolve around early 1700. The first modern recorded practice of future contracts happened at the Dojima Rice Market in Osaka, Japan. At this time, Japan was ruled by the Shoguns (Japanese Warlords). In order to win the support of the Samurai’s support, the Shogunate adopted a way of paying the samurai fixed amounts of rice each year. Low rice prices in the late 1720s affected the samurai’s finances and the shogun responded by easing restriction on future trading after they had been banned for some time which helped the samurai with a stable conversion to currency.
So How Do Futures Work Exactly?
A farmer producing corn could try to secure his income by negotiating a Futures Contract, and lock-in a selling price for next season’s crop. Suppose the farmer offers 5000 bushels of grain to be sold to a buyer in August. If a price of $5 per bushel is agreed, the farmer has secured an income of of $25,000. This way, the farmer is protected against a drop in prices. As the farmer is the delivering party, this is a short position. The buyer has a long position, and could be a cereal beverage maker trying to secure his profits by fixing his costs. He also would be protected by an increase in the price of grain.
If the actual price of grain per bushel rises to $6 by the end of the contract, it would mean a loss of $5,000 to the farmer. Without the Futures Contract, the farmer could have sold 5,000 bushels for $30,000. Due to the contract, the farmer is obliged to deliver 5,000 bushels at an agreed price of $5 per bushel. Likewise, the cereal beverage manufacturer would only pay $25,000 instead of $30,000 and therefore earn $5,000 on the contract.
Positions are however settled on a daily basis instead at the end of the contracts. Meaning that if the contract of $5 per bushel would be agreed today, and prices goes up to $6 tomorrow, then the gain and losses would be credited or deducted immediately.
The Concept of Hedging
If at maturity, the price of contract is still at $6, then the farmer would have a loss of $5000 deducted from his account as a result of the Future Contract. However, the farmer still has 5,000 bushels that can be sold at $6 per bushel in the spot market. The farmer would then receive $30,000 and pays $5000 to clear his debt. Likewise also the manufacturer also needs to to buy the grain which is currently now $25,000 in the spot market. Using the $5000 profit in his trading account, the manufacturer only pays $25,000. This scenario is called hedging
The Benefits of Bitcoin Futures
A Bitcoin trader can use Futures to lock-in a future Bitcoin prices resulting in a guaranteed profit for the trader. Same also, a Bitcoin borrower can take a loan in Bitcoin and use Futures Contract to lock-in the amount to be repaid. The prime advantage of Bitcoin Futures Contracts is that it becomes possible to manage price volatility also known as hedge in Bitcoin while others speculate on an increase or decrease in price.
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